XL Group: rethink the role of insurance - Angelos Deftereos

Senior executives at financial firms are being challenged to balance the demands of regulators and their seemingly continuous drive for ever-higher capital holdings with shareholders' desire for growth and improved returns on equity. Angelos Deftereos, senior underwriter - operational risks at XL Group, highlights how the issue of capital efficiency is spilling over into operational risk which, measured as a proportion of risk-weighted assets, has now overtaken market risk and stands second only to credit risk for many firms.

Banks and other financial firms are recognising that they can generate substantial additional value by following the example set by their peers and using insurance to offset their operational risk capital, as permitted under the existing rules.

Incorporating insurance into a component of their capital base allows these organisations to transform it from a means for recouping intermittent losses into a tax-efficient platform for supporting the continued growth of their business. A virtue of this approach is that, unlike some contingent capital structures, insurance compensation payments boost liquidity without diluting the stakes of existing shareholders.

This innovation is being driven by newly empowered boards, fuelled by improved internal reporting of risk information, and mandated by the regulatory 'use test' to demonstrate that risk factors are embedded into their oversight and direction of the business.

Senior leadership is taking advantage of powerful new tools for exercising direct oversight of operational risk governance and capital management. Metrics such as economic capital are highlighting the nexus between capital management and risk by quantifying the financial effect of operational risk exposures and the impact of risk-mitigation strategies, including insurance.

Breaking down barriers

Deploying insurance to maximise this benefit necessitates a rethink of the insurance programme design process. Regulatory standards require forging an explicit link between insurance policy terms of coverage and the significant risks identified through the scenario analysis, and risk and control self-assessment (RCSA) processes. Organisations are also motivated to synchronise insurance cover to their major risks by the prospect of improved claims recoveries from policies featuring cover transparently linked to exposures.

Communication with insurers is essential to finding the solution. However, the primary hurdles that must be overcome are often internal. To achieve the best results, boards must promote the breaking down of barriers between the various silos of risk management within their firms, and encourage the adoption of a common language of risk and capital impact.

In particular, close collaboration between the operational risk, insurance and capital modelling teams is crucial for ensuring the insurance programme is aligned with each firm's key risks.

Alignment will enable the impact of risk mitigation on capital requirements to be accurately captured in the model, as required by regulators. Equally, cooperation with the finance group is integral to selecting the most cost-effective capital structure.

The need to be firm

This more sophisticated approach to financing operational risk allows companies to be smarter with their capital, resulting in stronger balance sheets, better liquidity, quicker recoveries and enhanced returns.

Today, oversight of operational risk management and capital requirements is blending into a critical issue requiring firm leadership. Segregation of risk management functions is no longer a viable strategy. Successful organisations have grasped that an integrated approach to risk reporting, mitigation and capital management is empowering their boards, providing them with the tools to actively monitor risk controls and business performance.

While there is often resistance to change, the return is clear, and those organisations that receive clear board-level mandates on operational risk are most likely to positively adapt and reap the rewards of doing so.